Beat the IPO market at its own game

Amid a global IPO boom, investors can see floats as a do-or-die affair. They either join the dogfight and jostle for scraps in high-quality offers, or avoid them.

Another strategy is buying initial public offerings after they list. The first 12 months can provide stellar opportunities for ­investors who know where to look and who understand retail investors are disadvantaged in the IPO process.

Retail investors who complained about missing out on stock in star floats – such as
Virtus Health
,
Vocation
,
Veda Group
and
National Storage REIT
– or had their allocation slashed could have bought as much stock as they wanted after listing and still enjoyed strong gains.

“The real money in floats is made in the aftermarket – not through quick gains upon listing," says BT Investment Management head of smaller companies Paul Hannan. “Long-term investors make their money when high-quality floats prove their ­business model and promise through performance in the first few years after listing."

“The real money in floats is made in the aftermarket – not through quick gains upon listing,” says BT Investment Management head of smaller companies Paul Hannan.
AFR

Ed Prendergast, co-manager of the top-rated Pengana Emerging Companies Fund, says: “It’s a complete furphy that you have to buy stock in a float or you miss out. Quite often IPOs that don’t do well upon listing turn out to be the very best ones over three to five years. You are usually better off buying an IPO after listing, once the market noise has subsided and shareholders who have no loyalty to the stock and were always going to flip the IPO have done so."

Smart Money analysis of 63 IPOs in this financial year shows a median first-day or “stag" gain of 6 per cent – a fast return if you could get stock and were able to sell, but one that requires taking more risk compared to buying the same shares in the aftermarket.

About a quarter of those floats have posted double-digit gains from their first traded price, meaning investors who bought on-market rather than through the IPO have still enjoyed strong gains.

Education group Vocation, for example, is up 47 per cent from its first traded price.
SeaLink Travel Group
is up 16 per cent,
Meridian Energy
is up 27 per cent and ­
Affinity Education Group
is up 12 per cent.

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Not a one-size-fits-all rule

That does not mean all floats should be avoided or that all IPOs that perform well on their debut continue to trend higher. ­Investors who bought micro-jobs website Freelancer.com near its peak price on debut are nursing heavy losses, for example. It does, however, suggest investors who miss out on popular IPOs have an opportunity for strong gains in the secondary market if they are prepared to watch and wait for higher-quality companies.

Sacrificing early gains from investing through the IPO and buying six months or a year after listing – when there is more history as a listed company, a clean set of financial accounts and compliance with ASX listing rules and governance requirements – can be a smart move for long-term investors.

John Campbell, managing director of Avoca Investment Management, says: “I remain sceptical about buying stock in most floats during the IPO process. Investment bankers whip everybody into a frenzy about floats and, frankly, it’s become too much of a game for private equity firms, banks and analysts.

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“The immutable rule of IPOs is you get trivial allocations in good quality floats that are attractively priced but you can get as much as you want in the converse. Investors both large and small are generally better off buying after the IPO, and after the prospectus forecast period and escrows expire [the point when certain pre-IPO investors can sell], assuming there is sufficient value."

He adds: “If you invest in an IPO and get it right, it might add 10 basis points to your portfolio’s performance. But if an IPO misses forecasts, the price is inevitably smashed and your portfolio takes a big hit. It tends to be an asymmetric risk profile. You have to be mindful of the extra risks with IPOs."

Retail investors missing out the best floats, or securing a tiny fraction of their desired allocation, is hardly new. Predictably, most stock goes to the broking firm’s ­biggest clients. It is a similar story for ­institutional investors, with big fund managers getting more stock than smaller ones.

Investors can always buy IPOs after listing, and many small floats are desperate for greater after-market support from retail investors once their IPO publicity fades and life as a small listed company means low market profile and scant research coverage from analysts. Also, quality floats continue to post strong gains long after listing.

No longer an even playing field

What has changed in the past year is the playing field in IPOs becoming even more tilted towards institutional investors at the expense of retail investors, and the market’s propensity to slaughter floats with even the slightest negative surprise.

Morningstar head of equities research Peter Warnes is a scathing critic of current IPO practices for retail investors.

“Let’s face it, if a retail investor gets a big allocation in a float it’s usually because it is a dud. Institutional investors don’t want as much stock, so what happens? The brokers palm more of the IPO off to their retail clients. If it’s a good float, the retail investor seems to get less than ever," he says.

Warnes believes the book-build concept – a process where the IPO’s lead manager determines the offer price based on demand from institutional investors – is a travesty for retail investors. “The small investor has no control over the final price. It’s scandalous. You are relying on investment banks, who are looking after their own clients, to ­determine the final price. Then they leak it to the market that the offer was massively ­oversubscribed, to create even more hype."

Warnes says today’s IPOs have fewer ­safeguards. “In the old days, the IPO had a true underwriter who had to take risk and was on the hook if something went wrong. There was also better scrutiny of IPOs by ­regulators and the market. With fewer safeguards in place, there is a lot to be said for waiting a year or more after an IPO lists before buying."

Warnes agrees small investors are better off focusing on newly listed companies rather than chasing the majority of IPOs. “There are always exceptions. If a good-quality, well-priced float comes along and you can get stock, then of course you would buy it. But for the most part, retail investors should put IPOs on their radar, and watch if the company is under-promising and over-delivering in the first year after ­listing. If it is, they should buy."

The trend of shorter offer periods and more IPO stock going to cornerstone ­investors compounds the challenge for retail investors. Having a handful of fund managers take most available stock creates greater certainty for IPO vendors and reduces the risk of having a live offer in the market for months. But it means retail investors have even less opportunity to invest in IPOs that open and close quickly, often before mainstream investors even notice.

The issue of hedge funds

The influence of short-term funds in IPOs is another issue for retail investors.

Hedge funds, for example, are well known for dumping IPOs if they disappoint on debut, or fall too far below the issue price and breach the fund’s risk-management parameters. That can be a risk for those ­participating in the IPO and an opportunity for those buying in the aftermarket.

After raising $120 million
The PAS Group
in June tumbled from a $1.15 issue price to finish at 95¢ on its first day as listed ­company. It recovered to $1.02 a few days later, again on heavy volume. True believers in PAS were able to buy it 17 per cent cheaper on its first trading day compared with the offer price, while critics could argue PAS was overvalued at listing and needs to restore market faith over the coming year through performance.

Cadence Capital founder Karl Siegling usually sells an IPO if it falls below its issue price on debut. Siegling combines fundamental analysis with trend trading – buying rising stocks and selling falling stocks – and is known for taking big bets on out-of-favour stocks. “In our experience, a float that ­disappoints upon listing usually takes too long to recover, if it does at all," Siegling says. “We are very selective. All too often, private firms buy the asset, rip out the working capital, sell the property and lease it back, and then bring it back to market a few years later on four times what they paid for it. Nobody turns a business around that quickly."

Siegling prefers investing in corporate spinoffs, such as the divestment of Recall from Brambles, and Orora from Amcor this financial year. Cadence is likely to invest in the expected spinoff of Orica’s industrial chemicals business. ­

“Everybody wants to chase IPOs, but the spinoffs are a much better investment proposition," he says. “When you invest in a float, you basically know nothing about it the day before it lists because you are relying on what management says in the prospectus. With a spinoff, there is history – financial information has been vetted by the market and management is under pressure to make it work. The asset would not be divested if management did not believe it could create more value as a stand-alone business."

Check out the competition

Another strategy is focusing on the IPO’s nearest listed peer before the float. Fund managers that are fully invested sometimes take profits in a similar stock to free up cash to buy the float. For example, some managers may have trimmed their holding in ­Virtus Health to buy stock in the recent float of another In Vitro fertilisation provider, Monash IVF Group. Or they trimmed exposure to Austbrokers Holdings to partake in last year’s IPO of insurance broker, Steadfast Group.

The potential for the established listed company to underperform before its rival’s IPO and outperform three to six months after the float lists – when investor realise the incumbent company is worth a lot more than its new rival – has some strategic appeal for long-term investors.

These IPO criticisms could easily turn retail investors off buying stock in new offers. But there are key reasons to keep the faith in newly listed companies – the volume and value of IPOs in Australia is rapidly rising, the diversity of floats is the best in years and the listings quality is generally higher. This calendar year’s IPO market should be the best in a decade.

“We have been surprised by the ­quality of some IPOs in the past 12 months," says BT’s Hannan. “It’s refreshing to see good businesses coming to market."

The key question for retail investors is not just whether to buy floats, but when. On a risk-reward basis, the case for waiting and watching has rarely been stronger in a market that increasingly sees retail investors as “making the numbers" rather than as patient, loyal owners of newly listed companies.